The Capital Asset Pricing Model

Distinguish between diversifiable and undiversifiable risks and explain the implications
Discuss the content and assumptions of the Capital Asset Pricing Model
Identify and explain practical uses for Capital Asset Pricing Model
Describe the process of risk/return analysis

1. For each of the scenarios below, explain whether or not it represents a diversifiable or an undiversifiable
risk. Please consider the issues from the viewpoint of investors. Explain your reasoning
a. There’s a substantial unexpected increase in inflation.
b. There’s a major recession in the U.S.
c. A major lawsuit is filed against one large publicly traded corporation.

2. Use the CAPM to answer the following questions:
a. Find the Expected Rate of Return on the Market Portfolio given that the Expected Rate of Return on Asset is
12%, the Risk-Free Rate is 4%, and the Beta (b) for Asset “i” is 1.2.
b. Find the Risk-Free Rate given that the Expected Rate of Return on Asset “j” is 9%, the Expected Return on the
Market Portfolio is 10%, and the Beta (b) for Asset “j” is 0.8.
c. What do you think the Beta (ß) of your portfolio would be if you owned half of all the stocks traded on the
major exchanges? Explain.

3. In one page explain what you think is the main ‘message’ of the Capital Asset Pricing Model to corporations and
what is the main message of the CAPM to investors?

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